Vertical Issues in Federal Antitrust Law

It is a pleasure to be here in San Francisco, even with El Nino, to participate with such a distinguished panel in this ALI-ABA program on "Product Distribution and Marketing." This afternoon I will address vertical issues in federal antitrust law. Vertical antitrust issues arise in the context of relationships -- contractual or through merger -- between businesses at different levels in the chain of distribution; for example, between the maker of military aircraft and the maker of stealth radar technology. During my relatively brief tenure at the Federal Trade Commission -- barely six months -- I have dealt with several cases involving vertical antitrust issues and I have a new appreciation for the difficulty of this area of law.

Antitrust treatment of vertical restraints and mergers has vacillated over the years, in large part because vertical issues raise complicated analytic problems of how to resolve the conflict between generally acknowledged efficiencies stemming from vertical relationships and the potential for anticompetitive harm.(1) Both the courts and the antitrust agencies have struggled with two key issues related to vertical alliances:

First, how do they cause anticompetitive harm?

Second, how should the analysis treat the substantial efficiencies that they generate?

The answers to these questions are fact and case specific. Despite being somewhat of a newcomer to these issues, I will attempt to share some of what I have learned over the last six months and to discuss several recent Federal Trade Commission cases involving vertical antitrust issues. But first, I must make the standard disclaimer that the views expressed are my own and do not necessarily represent the views of the Commission or any other Commissioner.

AGREEMENT AS A THRESHOLD ISSUE

When analyzing any vertical relationship, a threshold issue is whether there is an agreement. An agreement for Sherman and FTC Act purposes is defined as "a conscious commitment to a common scheme designed to achieve an unlawful objective."(2) The evidence must show that the manufacturer and distributor did not act independently."(3) Determining whether an agreement existed, however, is not an easy task -- antitrust conspirators rarely sign a contract clearly spelling out the parameters of their anticompetitive agreement. Thus, antitrust enforcers must examine the totality of the circumstances.

RULE OF REASON ANALYSIS

The finding of an agreement is just the start of the inquiry. Most vertical alliances must be analyzed under a complicated "rule of reason," except in the area of minimum resale price maintenance, which is per se illegal. The rule of reason analysis takes account of many factors, including geographic and product market definition, market power, effects on intrabrand competition (such as competition among Ford dealerships), effects on interbrand competition (such as competition between Ford and GM dealerships), and any business justifications or offsetting efficiencies.

MINIMUM RESALE PRICE AGREEMENTS

An agreement between manufacturer and dealer or retailer on minimum resale price levels is per se illegal.(4) However, under the Colgate Doctrine,(5) established by the Supreme Court in 1919, a manufacturer may lawfully suggest prices and stop dealing with those who discount those prices, as long as it does so unilaterally. For example, manufacturers may suggest minimum prices (unilaterally) using a number of techniques, including:

A manufacturer may cut off a discounter in response to complaints from other retailers, as long as it makes this decision unilaterally.(9)Generally, the FTC does not challenge cooperative advertising programs in which dealers must use manufacturer-supplied information, including resale prices, in the advertisements. However, when dealers pay for their own advertisements, they must be free to price the product at whatever level they choose.(10)

Manufacturer actions that attempt to secure compliance with announced minimum prices may result in an improper agreement with the retailer. Such actions may include:

Last year the FTC issued a complaint and consent alleging that American Cyanamid fixed the minimum resale prices of its agricultural chemical products. Although the FTC's challenge of a minimum resale price maintenance agreement is not surprising, this case is particularly interesting because of the way in which American Cyanamid structured its dealer agreements. American Cyanamid operated two cash rebate programs for its retail dealers over a five year period. Under these programs, the dealers could receive substantial rebates on each sale of crop protection chemicals, but only if made at or above American Cyanamid's specified minimum resale price. The dealers overwhelmingly accepted the rebate offer by selling at or above the specified prices.

The FTC alleged a per se violation by American Cyanamid because a dealer could not receive a rebate on sales below the specified prices, and therefore would lose money on such sales. American Cyanamid also included performance criteria in its dealer rebate programs that could increase the amount of the rebate. However, if a dealer met all of the performance criteria, but sold the product for less than the specified minimum resale price, that dealer received no rebate on the sale. On the other hand, if the dealer met none of the performance criteria, but sold the product at or above American Cyanamid's specified minimum resale price, the dealer nonetheless received a rebate on that sale.

The FTC alleged that American Cyanamid's conditioning of financial payments on dealers' charging a specified minimum price amounted to the quid pro quo of an agreement. In other cases where this issue has arisen, courts also have treated such agreements as per se illegal.(14)

Another type of potentially problematic conduct is "structured terminations." These are unilateral, manufacturer-announced policies under which a discounter incurs increasing penalties for first, second, and third infractions for failure to sell at the minimum resale price. The FTC has banned such terminations as a part of "fencing-in" relief in a consent order, but has not ruled on their permissibility standing alone.(15)

Remedies in Resale Price Maintenance Cases

The FTC's selection of remedies in minimum resale price maintenance cases will be influenced by the willfulness of the conduct, whether the conduct led to the unlawful agreement, and the seriousness of its probable effects, measured in part by the market power of the manufacturer. For example, the FTC prevented Nintendo(16) from exercising its Colgate rights(17) to terminate or suspend retailers that did not comply with its announced pricing policy. This severe remedy was necessary because Nintendo commanded 80% of the market and, by virtue of this power, could have maintained its policy without an agreement because retailers could feel intimated.

MAXIMUM RESALE PRICE MAINTENANCE

As you heard this morning, after almost thirty years of per se unlawful treatment, in 1997 the United States Supreme Court reversed itself in State Oil Co. v. Khan,(18) and held that maximum resale price maintenance is not per se illegal. The Court explained that maximum prices could promote consumer welfare, under certain circumstances, by limiting the ability of a retailer to exercise local monopoly power.(19)

The Department of Justice and the FTC jointly filed an amicus brief in State Oil Co. v. Khan that stated, in pertinent part:

"We do not discount the possibility that there are cases in which vertical maximum price fixing may be, on balance, anti-competitive and therefore violate the Sherman Act. . . . Certainly, we do not advocate any rule declaring that vertical maximum pricing arrangements are per se legal. There is no reason to believe, however, that such anti-competitive situations will be frequent, or that those that may arise may not be adequately policed under the rule of reason. We are therefore confident that the loss of [the] per se rule will not materially hamper the federal government's ability to enforce the antitrust laws vigorously in any appropriate case."

It is important to remember that State Oil Co. v. Khan does not immunize maximum resale price maintenance; rather, it requires the courts and agencies to examine such arrangements using the rule of reason.

Non-price vertical restraints include exclusive dealing and exclusive distribution agreements, and both are assessed under the rule of reason.(20)

In exclusive dealing cases, a manufacturer arranges for a retailer (or customer at some other level) to carry only the manufacturer's line of products, and not the products of a competitor. In exclusive distribution cases, instead of retailers committing themselves to a single manufacturer, the manufacturer commits itself to a single retailer to be its sole (or primary) outlet in a particular geographic area. The FTC assesses both exclusive dealing and distribution arrangements using the rule of reason.(21) The ultimate question is whether competition has been harmed by the exclusive dealing or distribution arrangements -- that is, has the firm imposing the exclusivity gained power over price?

Thus, exclusive dealing may be procompetitive when it encourages retailers to invest in promoting the manufacturer's line, thereby enhancing interbrand competition at the retail level.(22) For example, when Ford Motor Company requires its dealers to sell only Ford cars and trucks, generally this would be procompetitive because General Motors has a similar arrangement with its dealers; thus, there is more aggressive competition between the Ford and GM retailers. Similarly, exclusive distributorships can be procompetitive and normally are permissible, particularly when competing manufacturers, selling through other retailers, also are present in the market.(23)

Exclusive dealing and exclusive distribution arrangements may be anticompetitive, however, if they are used to raise rivals' costs, exclude (or foreclose) competition, or facilitate tacit collusion. Exclusive dealing contracts may raise rivals' costs when the contracts are made with so many retailers, and lock up so much capacity at the retail level, that competing manufacturers are unable to attain minimum efficient scale in either the production or the distribution functions.(24)

In the recent cases against Waterous Co. and Hale Products, the FTC alleged that the two dominant manufacturers of fire-engine pumps each entered into exclusive dealing agreements with certain manufacturers of fire engines. The FTC was concerned that these exclusive deals facilitated tacit collusion and functioned as a means of allocating customers.

In exclusive distribution cases, a retailer may effectively raise a rival's costs by securing commitments from a sufficient number of manufacturers to prevent a rival from: (1) attaining economies of scale or scope; (2) obtaining low-cost supplies; or (3) obtaining products necessary to satisfy consumer demand. For example, if Sears obtained the exclusive rights to be the sole distributor of appliances made by Maytag, General Electric, and other large appliance manufacturers, such exclusivity could have an anticompetitive effect on other retailers, such as Montgomery Ward and Penney's.

VERTICAL MERGERS

Vertical mergers occur between firms that operate at different but complementary levels in the chain of production or distribution. Common examples include a merger between a manufacturer and a distributor (for example, between a drug manufacturer and a pharmacy benefits manager) or a merger between two manufacturers, one of which produces an end product and the other a component used to make that end product. As with non-price vertical restraints, vertical mergers often can be efficiency-enhancing.

However, vertical mergers also can have anticompetitive effects. Vertical mergers can allow competitors to raise rivals' costs.(25) For example, Eli Lilly, a drug manufacturer, could make it more difficult or expensive for competing drug manufacturers to distribute their drug products through Lilly's wholly-owned pharmacy benefits manager, PCS. Vertical mergers also can facilitate coordinated interaction; for example, when the downstream level of the integrated firm receives competitively sensitive information from the competitors of the upstream level of the integrated firm such information could be used to coordinate marketplace behavior.(26) In connection with the Lilly/PCS merger, the FTC was concerned that Lilly would be in a position post-merger to obtain from PCS sensitive pricing and bidding information submitted by other drug manufacturers. Such information could allow Lilly to underbid its competitors in an anticompetitive manner.

Some common remedies used in connection with vertical mergers include:

Prohibiting the integrated firm from denying competitors access to necessary manufacturing inputs or distribution outlets for its products;(27) and

Establishing a "firewall" to prevent companies from gaining access to a rival's competitively sensitive information.

The Commission continues to investigate proposed vertical mergers and to require consent agreements when appropriate.

CONCLUSION

Thank you for the opportunity to share with you some of my preliminary observations about the complex and intriguing area of vertical restraints.

17. "Colgate rights" refer to a manufacturer's right to suggest prices and cease dealing with those who do not adhere to those prices, as long as it does so unilaterally. See United States v. Colgate & Co., 250 U.S. 300 (1919).